'The great mutual fund trap'

Commentary: Former Treasury officials expose industry

LOS ANGELES (CBS.MW) -- This is a must-buy. It should be in every Main Street investor's library. In fact, "The Great Mutual Fund Trap" is so good I could cry.

Yes, cry: Not because it's well written and entertaining. Not because it's the God's honest truth. Not because we see funds through the eyes of former Treasury insiders. And not because it offers investors the perfect solution out of "The Trap."

It's because the fund managers' tenacious lobby will continue fighting the industry reforms this book makes clear are needed. So I'm afraid nothing will happen. The industry will continue taking advantage of investors. And that's enough to make anyone cry.

Fortunately, reform is possible: The authors of "The Trap" speak from considerable experience as ex-Treasury officials. Gregory Baer was assistant secretary for financial institutions, following an earlier post as managing senior general counsel at the Federal Reserve Board. Gary Gensler was an undersecretary who previously was co-head of finance at Goldman Sachs. Today, he is an advisor to Sen. Paul Sarbanes, D-Md., on the Senate Banking Committee.

An investor's worse nightmare

What distinguishes "The Trap" is this: While most recent books on investing and personal finance focus on Wall Street as the evil giant, this one focuses on America's new evil giant, the mutual fund industry, which for years has portrayed itself as Main Street's protector against Wall Street's robber barons.

Not so. As Gensler and Baer point out, it's becoming painfully clear that the fund industry is emerging as the fund investor's worse nightmare, overloaded with secrets outlined earlier in our column on the industry's "conspiracy of silence," 25 areas where fund managers hide information from investors.

Gensler and Baer do a great job of exposing most of the issues. Here are a few.

Active managers, hidden costs

When asked why they titled the book "The Great Mutual Fund Trap," Gensler and Baer said investors are "trapped into believing that 'experts' can help you beat the market, whether (with) actively-managed mutual funds or great stock-picking fund managers." Unfortunately, they point out, every method used to pick winning funds has failed to beat the market.

Gensler and Baer point to research showing over and over that active fund managers underperform the market. On the average, their entire portfolios turnover every fifteen months, triggering high commission costs, excessive management costs, substantial bid/ask spreads, and highly taxed, short-term capital gains. All that reduces investor returns.

A simple solution

The authors warn that "by their very nature the financial media can inadvertently lead you astray. Asset allocation is boring. Diversification is boring. Index fund managers are the earth's most boring guests. So you don't often hear about these things in the media - it doesn't make for good reading or viewing!"

"What is exciting? The newest hot stock or sector, celebrity analysts, mutual fund managers and CEOs. While they may be exciting, these stories often lead investors further into the 'trap' of relying on the experts in a fruitless effort to beat the market."

Indexing offers diversification, low fees, no sales loads, and tax efficiency for investors who add small amounts on a regular basis. And for larger chunks (like a bonus or inheritance) they recommend really boring exchange-traded funds.

Want to get even more boring? Bond index funds.

Better yet, try direct purchases of bonds, a no-fee, tax-efficient strategy. Buy direct from the Treasury and many big companies. Other truly boring solutions? "529 plans are the now best deal going in investing!" Totally tax-free. Boring like a fox!

"The Trap" is anything but boring.

How about 401(k)s? More boring stuff. "Three lessons: diversification, diversification, and diversification. Ideally that means a total market index fund" like a split between Vanguard Total Stock Market Index Fund
VTSMX, -1.54%
and Vanguard Total Bond Market Index
VBMFX, +0.19%

They also warn investors to avoid all of the industry's hit new financial products like wrap accounts, they're just "old ideas and services repackaged." And forget about the biggest loser's game, market timing. "The reason Wall Street likes market timing is because it makes investors trade stocks, which makes them money, not investors!"

Gensler and Baer save their strongest criticism for Social Security privatization: "It would be one of the single greatest wealth transfers in American history - from America's retirees to the financial services industry. The transaction costs and fees drained out of Social Security would total over $10 billion per year."

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